Trusts are legal arrangements that hold properties and other assets on your behalf. Those assets are distributed to designated beneficiaries after your death according to the terms you set forth when creating the trust. Setting up a trust can be an integral part of estate planning, and choosing the right type of arrangement can minimize the estate and gift taxes that your loved ones would otherwise have to pay. In this article, you’ll learn about one available option: the ILIT trust.
What Is an ILIT Trust?
ILIT is an acronym for irrevocable life insurance trust, which is a type of living trust that’s created for the explicit purpose of owning and controlling one or more permanent life insurance policies while the insured individual is alive. Upon the death of the insured, the ILIT manages and distributes proceeds from the death benefits. An ILIT gets its name because once it has been set up and funded, it can’t be amended, modified or rescinded.
How Does an ILIT Trust Work?
When an ILIT is set up, the trust becomes the primary beneficiary of one or more life insurance policies. Accordingly, the trust receives the death benefit payout after the insured dies. The money is then held in trust for the individuals who’ve been named in its terms and then paid out according to the guidelines set up when the trust was created.
What Is the Purpose of an ILIT?
As part of the estate-planning process, an ILIT trust can serve several purposes. Here are a few of the main reasons why you may want to look into an ILIT.
Minimizing Estate Taxes
By granting ownership of your life insurance policy to an ILIT, you prevent the policy’s death benefit from being included in your taxable estate. Essentially, because the policy is owned by the trust, it isn’t subject to estate taxes from either federal or state governments.
An ILIT trust can also minimize estate taxes on other property. By transferring property and other assets into the ILIT, you can significantly reduce your taxable estate. That makes this a potentially good choice for high-worth individuals whose estates may be subject to heavy taxes.
Because ILITs can provide liquidity, they can be used to help pay any estate taxes that your beneficiaries incur. This means your loved ones can more easily preserve other important or unique assets that they might otherwise have to liquidate for funds.
Protecting Beneficiaries' Government Benefits
Receiving proceeds from a life insurance policy’s payout may interfere with a beneficiary’s government benefits. Because the ILIT’s trustee controls how trust distributions are used, payments can be structured so as not to jeopardize a beneficiary’s eligibility for government benefits such as Medicaid or SSDI.
If you’ve created an ILIT, the benefits don’t automatically have to be distributed immediately upon your death. During the creation of the trust, you can set the terms for disbursement of life insurance death benefits and other contributed assets. Terms for distribution may take on several forms:
- Lump sum payout
- Regular payouts that last as long as there’s money left in the trust
- Payout when the beneficiary reaches a certain age
- Distributions at specified milestones such as marriage, college graduation, childbirth or the purchase of a house
Although you lose primary control of any assets contributed to the ILIT, the trustee named when the trust was created may also have the discretionary power to control how and when distributions are made, guided by the terms you set forth in the trust. This can be especially useful in the following situations:
- Second marriages
- When the beneficiaries are minors
- When the beneficiary has a history of financial irresponsibility and reckless spending
- When the beneficiary has a history of drug or alcohol dependency
Protection From Creditors
Because the ILIT holds the assets, they’re typically protected from creditors seeking reparation from either the grantor or the beneficiaries. However, once funds have been distributed, creditors may have access to them.
What Is the Downside to an Irrevocable Trust?
An ILIT can be an integral part of a successful wealth management plan, but there are several downsides to this type of trust.
Once the trust is set up, it’s permanent. Because an irrevocable life insurance trust can’t be rescinded or amended after it’s been created, any property contributed to the ILIT can’t be reclaimed under any circumstances by the grantor. Make sure, before you set up this type of trust, that you won't need to access life insurance benefits to cover care if you're diagnosed with a critical or terminal illness, as provided for in the policy. You should also know exactly how you want your assets distributed to beneficiaries because the terms can't be changed once they are set.
Tax Burden on Descendants
ILIT assets are not considered part of your estate and, as such, are not taxable. However, once assets are transferred to your beneficiaries, they become part of their estates, potentially creating a larger tax burden for their descendants after they die.
Is There Any Way to Dissolve an ILIT?
An ILIT can’t be dissolved or rescinded once it’s been created. However, if the life insurance policy it holds isn’t paid in full, you can simply stop paying your premiums. Once the policy lapses for nonpayment, the trust essentially becomes an empty vessel.
Should I Hire a Professional Estate Planner to Create an IRIT Trust?
For most people, the answer to this question is yes. Setting up an ILIT is a complex process, and to conform to IRS guidelines, the set up process must follow strict drafting and procedural rules. Unless you have legal experience with trusts, you probably shouldn't try to set one up without the right assistance. A seasoned estate lawyer or a financial professional who specializes in estate planning can help you ensure that all paperwork is properly filled out and filed to maximize the benefits of your trust.